May 1, 2008 | posted by Michael Baxter in credit crunch |

Squint a little, and keep looking, that could be light at the end of the tunnel.

The reason for hope came with two separate pronouncements, both in the UK and the US.

In the US, Treasury Secretary Harry Paulson, and remember by the way, he is a former CEO of Goldman Sachs –  said that while the credit crisis is now nine months old – it is more than halfway though its life – in other words, things should be back to normal by about the end of the year.

But, why the hope?   Well it’s that age old story –  markets have overdone the reaction.  Regulatory requirements have not helped.  Banks are being forced to make write-downs which in their heart of hearts they believe are too pessimistic.  For example, HBOS recently announced a £2.9bn write-down of its mortgage assets – although, as was pointed out by Jeremy Warner in the Independent today, it believes that, actually, it will get all of its money back in the end.

And that is why yesterday the Bank of England, in its latest financial stability report, said, “The pricing of risk in credit markets seems to have swung from being unsustainably low last summer to being temporarily too high relative to fundamentals. So, while there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months.”

Or to put it another way, now is the time to buy back into mortgage debt.

Now, hold your horses – that doesn’t mean you.  Well, not unless you trade in many millions of assets.      No one is yet saying now is the time for retail investors to jump back in, not yet, but credit securitisation is now priced such that one assumes there are people out there – wealthy people, maybe people who control sovereign wealth funds, who will be tempted to start buying again.

Right now is also a time of opportunity for banks with strong balance sheets, which is why HBOS seems to have made the right decision with its rights issue – even though it says it could struggle on without the extra cash.

And John Gieve, deputy governor at the Bank of England, summed it all up rather nicely when he said, “While there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months.”

The Bank of England is in effect saying that we are seeing a natural cycle.

It’s as old as the hills.  And actually quite ironic,  when you think about how clever the City and its whiz-kids are, for it seems they have been repeating the error of Arctic hares and lynxes.

In his book, Why Most Things Fail, Paul Ormerod told the story of how statisticians in Hudson Bay had observed  a regular cycle in the population of these two species.   Further study revealed that when the population of hares in the region was high, the lynx thrived and its populace increased in size rapidly, until the predators were consuming hares faster than their long-eared prey was able to reproduce.  As a result there was a shortage of hares, and a greater effort was required by each lynx to catch its dinner.  In time, mass starvation of the lynx occurred, and its population fell rapidly, the hares then found little impediment to their own struggle for survival, until eventuality the cycle repeated itself.

The mistake these two creatures were making was that they were not seeing the big picture.    Each boom caused the next slowdown because they failed to take into account that the actions of individual hares and lynxes were being duplicated across the entire population.

In business it’s a pattern we are all familiar with – yet we seem unable to learn.

Ten years ago, Long Term Capital Management (LTCM) was supposed to have boasted a foolproof model – designed by winners of the Nobel Memorial Prize in economics. It employed a highly sophisticated mathematical model that supposedly could only make money – but it failed, and nearly dragged the global economy into recession.

The reasons for LTCM’s failure are complex – but it appears that its mathematical model failed to take into account the way markets overreact one way, then when it goes wrong, overreact in the other direction.

It was thus at Northern Rock, they risk-assessed their business model – but failed to grasp that other banks were behaving in a similar – albeit less extreme, way, so that when the market turned, the Northern Rock business model ceased to function.

The securitisation of debt persuaded banks to take more risks with their lending because they were selling the risk on.  But at the same time they were buying risk from other banks.  If you like, they were suffering from eating the poisoned meat they were producing as they spread it out across the system.  But at the same time, however, they were eating poisoned meat that others produced.

So, first the credit markets became too exuberant.  But now, just as before they experienced exuberance en masse, banks are experiencing caution en masse.  That’s fine when one bank behaves like that, but when they are all at it, they are in effect making things worse.

It’s classic herd instinct.

And that’s why there is opportunity – right now the savvy are realising this.

Banks are now making assumptions about sub-prime default in the US which are far, far too pessimistic.   According to the FT, for the fears that are being reflected in market prices to be appropriate, around 76 per cent of all US sub-prime debt sold in 2007 would have to default – with just 50 per cent of the money owed repaid.

The IMF is not helping much either, says the Bank of England.

You may recall, the IMF estimated total losses relating to the credit crunch will come in at $945bn – yet it based this figure on market prices.  In other words, it looked at the price markets were allocating to debt securitisation – and said if the markets are right, this is what total debt will be.    In effect, it told markets what they already knew, but in doing that it seemed to confirm worst fears – and somehow make market estimates of total losses more likely to be right.

But does all this mean that we just have to be patient, and wait for the natural cycle to move to the next phase?

The answer to that is a resounding no. 

Yesterday, the Bank of England made it clear that there was a danger that the fears surrounding financial circles could become self-fulfilling.

There is a danger, said the Bank, that “the currently elevated risk premia in some markets will persist…This could lead to a self-fulfilling adverse cycle in which persistent market illiquidity and falling asset prices further undermine confidence in banks and results in a sharper tightening of credit conditions.”

We told yesterday how actually house prices would need to fall by over 25 per cent, before negative equity levels approach anything like the levels seen in the early 1990s.    The danger has to be that the banks in mass panic mode make credit so tight, that this worst case scenario actually occurs.

That is why, says the Bank of England, it was right with its recent £50bn rescue package, and why it may well repeat the trick in the future.

Right now, the Bank of England’s job is to save the banks from themselves.   Returning to Hudson Bay, it is as if the lynx got too clever, so that it caused the complete extinction of hares – which in turn was leading to its own extinction – forcing the gamekeeper to import hares from another region.

In the longer-term, however, there is a danger that the lynx will once again drive the new population to extinction, so somehow the gamekeeper has to make the predator less efficient – and this is analogous to the moral hazard argument used by central banks.